India Declares, 'We're Back in Business'

India, a nearly $2 trillion economy and Asia’s third largest, has woken up to declare it's back in business.

Recent policy initiatives to woo foreign capital, boost growth, and trim expenditure have come as a pleasant surprise for investors who until a few months back nurtured little hope for the economy.

With recent “big bang” reforms, the Indian government has in one shot turned investor sentiment around, according to experts and analysts.

In September, the government opened up the retail, aviation and broadcast sectors to foreign investment, raised the price of fuel, cut taxes on overseas borrowing and announced partial privatization of four state-run industries.

“Contrary to most people’s belief, this government is prepared to introduce controversial structural reforms and stick to it in the face of opposition,” said Robert Prior-Wandesforde, director of Asia Economics at Credit Suisse .

India’s coalition government led by Manmohan Singh has been accused of “policy paralysis” that has prevented it from delivering unpopular fiscal reforms. It has also baffled investors with several policy flip-flops. (More:Bollywood Goes Global)

For example, last year foreign direct investment in retailing, which opens the doors for supermarket chains like Wal-Mart , was cleared and then stalled by the government.

But this time around, despite severe opposition and political setbacks, the government has not gone back on its promises — at least not yet — raising hopes in the investor community that India is serious about getting its house in order.

“I do have a fairly high degree of confidence that the reforms that have been announced will be delivered,” said Prior-Wandesforde.

A ballooning fiscal deficit, grindingly slow growth and unsustainable inflation, together with falling asset prices, pushed the government to take bold steps.

“These reforms have certainly lifted investor spirit. It has raised confidence that India is charting the right course,” said Frederic Neumann, co-head of Asian Economic Research at HSBC .

Indian equities and currency both got a boost from recent measures. The rupee, which reached an all-time low of more than 57 against the U.S. dollar on June 22, has since recovered more than 8 percent, helped in part by the September reforms. Indian equities, which have had a good year so far, have also gained about 8 percent in September. (More:10 Hot Indian Startups)

“Even though the recent measures announced by India may be called an ‘after thought,’ they are still seen as an opportunity by offshore investors,” said Cyrus Daruwala, managing director, Asia Pacific IDC Financial Insights.

His company, a wholly owned division of U.S.-based investment firm IDG Ventures, sees India among the top five investment destinations in the world. Indian assets make up close to 30 percent of the company’s total Asia Pacific portfolio, which stands at $12.5 billion.

“India is a buy, a good long-term global hedge given its strong domestic market,” said Daruwala. Private consumption contributes close to 60 percent to India’s gross domestic product.

India vs. China

Strong domestic consumption, favorable demographics, low labor costs coupled with lower leverage are some of India’s strengths that have some economists rooting for India over China.

HSBC’s Neumann argues that higher debt levels and a greater reliance on investment make China vulnerable to global financial shocks. “The risk of a hard landing is greater in China given these structural challenges,” he said.

“India, by contrast, suffers from insufficient investment and higher inflation, both of which can be more easily corrected by policy adjustments," said Neumann.

Inflation in India is above 7 percent, while foreign inflows are a trickle compared to China’s over $100 billion in foreign direct investments annually.

But a “much younger population and thus far lower wage pressures will eventually allow Indian firms to gain market share in global exports, pushing the country's growth rate up while China's will inevitably decelerate,” believes Neumann. (More:Why Are Indians Suddenly Buying Diamonds?)

For Daruwala, India is in a better position than China to weather the slowdown in global demand. “With consumption in the U.S. and Europe slowing down, China's production, output and jobs may be the worst hit,” he said.

Prior-Wandesforde points towards the performance of the two countries' stock markets as an indicator of investor confidence. “India’s outperformance versus China is significant.”

Both countries saw a drop of more than 20 percent in their stock markets last year, while India’s has recovered this year to post a gain of nearly 22 percent year to date, China’s is down about 4 percent.

Cautious Optimism

Despite this rapid change of mood toward India, which until a few months ago was threatened with a credit downgrade to junk status, huge challenges still remain and experts warn against getting carried away.

“Earlier the mood was worse than reality, and now the mood is better than reality,” said Rajeev Malik, senior economist at brokerage CLSA Singapore. He added that “it’s a gross exaggeration to label the reforms as ‘big bang.’ They are overdue moves that are welcome and constitute a good start. But the government needs to do a lot more.”

In a politically risky move, India raised the price of heavily subsidized diesel by 14 percent for the first time in 15 months on Sept. 13 in an effort to curb the fiscal deficit at 5.8 percent of GDP. While this will limit fiscal overshoot, it will have a minimal effect on its subsidy bill, said experts.

“India needs to cut subsidies further … the reforms so far are just the beginning of a long and painful process. It is not the magic key to 9 percent growth,” said Neumann.

Economic growth in India has slowed to around 5.5 percent this year, a far cry from the near 9 percent growth rate a couple years back, and even the most optimistic don’t see India returning to those growth rates in the next few years.

But the long-term story stays intact as long as India can convince investors that they are not going to renege on decisions and continue with further reforms, said experts.

This may not be easy given the fact that the government faces an election in 2014, and politics could trump economics. “Expectations have risen. Hopefully, the government will come through with some constructive action … fingers and toes crossed,” said Malik.